Sunday, November 30, 2014

Another way to look at stock selection and market direction

In this post I talked about my recent performance, and the erosion of profits made earlier in the year. To recap, it wasn't necessarily the trades that I took that were the problem, it was the trades that I DIDN'T take. And this was a result of paying too close attention to the general market. But first, some background.

There is a 'top down' theory that has been successfully used by traders for decades - Jesse Livermore was one such exponent. You initially look at what the general market is doing, which may determine whether will look for long or short trades, before identifying individual stocks that you may want to trade.

This also formed part of William O'Neill's CANSLIM theory, his basic assertion is that 3 out of 4 stocks tend to follow the major market averages.

However, there is another way.

What are we trading here? I am looking to trade individual stocks. I'm not trading the indices (although if the indices itself gave a signal I may decide to trade that). Therefore, if I am trading an individual stock, then my primary concern should be it's own price action.

Thinking about this further, I have always believed that, once you are in a trade, then price action in that stock alone will dictate when you get out. If I am long a number of positions, and the index starts falling, is that a consideration? To me no, it never has been. So, if what is going on in the general market at the time of exit isn't a consideration, should it also be of little importance when I am opening a new trade?

I think back to July 2013, when I had an explosion of profits in a few trades which lead to big gains (go here for more). Some of a few of these trades were initiated when the indices were trading flat at best, or were actually dropping. One such example was shown here.

In the UK, the major FTSE index has basically been in a trendless state since May 2013. However there are obviously stocks which have generated significant trends in that time - long or short. In other countries, where the general market has been trending, and may have hit multi-year or all-time highs, there have been plenty of stocks developing significant trends in the opposite direction.

As an alternative then, you may want to consider using some form of longer-term trend 'filter' on the individual stocks themselves, which may act as a signal to only look to trend in one direction or the other. Below are some recent charts where I have overlaid a 50 day EMA as such a filter. So, using this, you would only take long signals given when the price was above that filter. Longer term traders or investors may want to use the 200 day moving average as the filter.

Based on my own stock selection criteria, all these stocks were valid set ups - indeed, a couple of these I did have on my own watchlists ready to trade. However, because of my pre-occupation with what the general market conditions were at the time, I did not take the signals!

Looking back at the FTSE since I started trading back in 2003, the current tight consolidation, over the last 18 months or so, is unprecedented (go look at a monthly chart and you will see what I mean). Therefore, I am viewing this period as part of the never-ending evolution and development of my own trading.

I would also say that, in this period, some traders I know already subscribe to this theory of concentrating solely on the stock's price action. Consequently, while I have lost money they have made money, even though we are all looking for price trends.

Simply taking one or two of these set ups shown below, and the multiple R profits they would have generated, would have covered a high proportion of those small losses, and may have left some profits over. And that's before we even talk about trends in instruments like oil, silver, and some of the Yen forex pairs in the same period!.

Now, some people would still say that you have to factor to in what the markets are doing, and I wouldn't necessarily disagree. However, what level of importance you place on it is up to each individual trader.

As with all things trading, there is no right or wrong here - these two different theories make logical sense. What your own belief is, and how you factor it into your overall plan, will be the right way for you.








6 comments:

  1. Great post. Trading is constant evolution, constant learning about the markets and the self. That's one thing that makes it so great. Always testing the self, always growing, always getting better.

    I tend to go with the individual stock action and pay little attention to the broad market. Trying to time the broad market just adds another layer of complexity and difficulty. Also, trading the leaders/laggards means they are bellwethers of the broad market anyway, so they will likely stop you out before the market turns in the opposite direction.

    Also, I find it is very important to manage my overall exposure long and short and to individual industries. Reducing correlations as much as possible is very helpful in my opinion to manage portfolio volatility and risk.

    Best of luck. I really enjoy your posts.

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  2. Hi Steve,

    Firstly, good job for this informative and well written blog. As a trend follower myself, I find nodding in agreement with most of the stuff in this blog. As you mentioned in this post, I am curious what makes you not to take a trade when a signal is generated?

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    1. Thanks for the comment and kind words. I will try and explain more in my post 'My plan for 2015' which I am currently writing up.

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